13 Consider Figure 23.7, which depicts a scenario in the Rothschild-Stiglitz of
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13 Consider Figure 23.7, which depicts a scenario in the Rothschild-Stiglitz of adverse selection. Uf UR Figure 23.7. Potential pooling equilibrium is threatened by contract . IH Explain why is not a valid pooling equilibrium. Explain why your answer to the previous question depends on an assumption that expected utility theory holds. a b c Suppose the Pcoran government is trying to maintain as a pooling equilibrium to ensure universal insurance for its long-suffering populace. The government health minister is familiar with the work of Kahneman and Tversky and wants to take advantage of the fact that Pcorians are loss averse and susceptible to framing. When a private insurance company begins offering contract , how should the government frame the tradeoff between and to try to keep robust customers at ?Explanation / Answer
Suppose Is is the accident state and IH is the non-accident state. The point E represents the uninsured state. The actually fair line above E represents the healthy individual and the actually fair line below E represents the sick individual. An actually fair line represents every possible insurance package that makes the insurance company profits zero. So the amount of money these companies decide to take in from consumers is equal to the amount of money they expect to pay out, given the probability of individuals getting into an accident. So, the healthy person’s line is a lot steeper because there is going to be a lot less money taken out of the person’s paycheck every month in the non-accident state. The x-axis coordinate here is essentially an individual’s wage minus the insurance premium he pays. And, the y-axis is going to be proportionate to how much these companies pay out. In the centre we have the pooling line which pools both healthy and sick people together. The point on the pooling line represents an insurance package in a state of the world where every single insurance company is offering as the pooling package. An insurance company can come in and disrupt the equilibrium by offering cream skimming package . When is offered, it is going to be up the utility model for healthy people. Hence, the healthy individuals are going to be attracted to package . The sick people however, will not be attracted to because it is down the utility model for them. They will prefer over because is on a higher point of their utility model. Thus, by disrupting the pooling equilibrium by offering package , insurance companies are able to make profits greater than zero.
It is based on the assumption that the expected utility theory holds because consumer preferences are captured by the Indifference curves. The sick people’s indifference curve UF is relatively flatter and the healthy individuals indifference curve UR is fairly steep. Thus, the indifference curves tells us the way in which each individual is preferring the package and which direction is up for them in terms of gaining utility and which direction is down the utility model in terms of losing utility. Since, healthy people like paying less and they don’t care so much about the accident phase, insurance companies are able to cream skim them away.
The Key to government intervention is that they mandate participation. No one can opt out. Government can find a program that is a pareto improvement over the current equilibrium
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